NCUA Uses PIMCO to Implement New Accounting Practice: Mark-to-Model

Rather than matching investment losses as incurred, either from payment defaults or bond sales, NCUA has required all credit unions to expense today these loss estimates which go out years into the future. Chip Filson proposes a better solution, one that is consistent with how cooperatives generate capital, that is from future earnings.

NCUA’s release of the much touted PIMCO report on April 17 was little more than an ad brochure for the firm. There was no data for understanding the firm’s or NCUA’s analysis of any corporate’s portfolio. If a corporate credit union had given this information to NCUA as the basis for their estimates, examiners would have said, “Not good enough—show us the numbers!”

The discussion over PIMCO’s analysis however is obscuring a larger issue. NCUA has decreed that credit unions must expense $10 billion based on their analysis of the corporate network’s investments. Part of this expense is the systemic losses via the NCUSIF assessments; the remainder is the $4 billion capital at WesCorp and U.S. Central which the Agency says is gone.

The Use and Misuse of Models

But how was this $10 billion expense, for which every credit union is booking a pro rata share, estimated? With modeling. Below is a simple example of a bond in WesCorp’s portfolio for $105 million, CUSIP 751153AC1. The bond is a senior tranche, originally rate AAA at the time of purchase and now rated B or Ca depending on which rating agency is used.

This sample analysis uses Bloomberg analytics. Three input assumptions drive virtually all bond models:

  1. the rate at which the underlying mortgages are assumed to prepay faster than contractual payments (cpr),
  2. the default rate on the underlying collateral (% of loans going to foreclosure) and
  3. the average loss estimated on these foreclosed loans, or severity.
The chart below shows these three numbers: 9.5 CPR, a 10% default rate and a loss rate on loans foreclosed of 60%. These are all based on economist’s estimates of future trends.

Using contractual payments plus CPR assumptions, the cash flows are then modeled on Bloomberg. These show a potential loss on underlying collateral of $15 million beginning in the year 2016.

Citing PIMCO and their other models, NCUA is requiring credit unions to expense this possible loss today. This new regulatory accounting is forcing the entire industry to “mark-to-model” a process even NCUA says could result in different estimates whenever models are rerun.

Other Models, Other Answers

Bloomberg is not the only modeling option available. Other firms allow more complex variations in the assumptions such as changing the loss severity over time. But every model is driven by assumptions. The three key drivers are inputs above which are chosen using economic and statistical data such as unemployment trends or housing sales.

Virtually all models produce forecasts of cash flows and possible credit defaults over the life of the bond. Some even convert these to yield-to-maturity estimates so a portfolio manager might compare different predicted outcomes in deciding which bonds to hold. What models do not produce is a single “fair market price;” rather there are multiple outcomes from various scenarios or discounted cash flow assumptions.

While models offer the allure of precise numbers, they are simply tools which depend on economist’s inputs. Sometimes these economic predictions can make weather forecasters look good. So, rather than matching investment losses as incurred, either from payment defaults or bond sales, NCUA has required all credit unions to expense today these loss estimates which go out years into the future.

The consequence of this $10 billion upfront expense is to reduce net worth ratios across the system. This in turn constrains every credit union’s lending and savings growth. Just when members need credit unions the most, NCUA’s actions are causing credit unions to pull back.

At a 10% average capital level, the impact on members is to reduce savings growth by $100 billion and loans by the average loan-to-share ratio, which today is 82% or $82 billion. If a credit union’s capital ratio is lower, the impact is even greater!

Instead of supporting credit unions unique “counter cyclical role” in today’s troubled economy, NCUA’s mark to model methodology has just the opposite impact. It puts credit unions under the same constraints as other market driven lenders.

A Better Solution

A better way to meet the expenses from corporate losses would be to assess an insurance premium as these events are incurred over the next four to six years. A 10 basis point premium on a $250,000 maximum insurance coverage, assuming 8% share growth, would generate almost $5 billion in premium in just six years.

This is the solution that fits not only credit unions’ role today, but also is consistent with how cooperatives generate capital, that is from future earnings.

NCUA’s PIMCO “report” failed to meet any standard that would clarify the numbers the Agency is using. However the real issue is the policy failure that imposes costs on the system today for estimated future losses. No other regulatory agency, bank or other institution is using this practice. So why are credit unions?




April 27, 2009


  • We believe that there are opportunities to “turn the ship around” as Congress debates HR 1106 and the credit union-specific segments. Stay tuned…we will be proposing a framework for action through the new advocacy site, at the end of this week.
    Alix Patterson
  • Excellent commentary and graphics to clearly delineate a material flaw in NUCA's leadership & guidance on this very critical matter. Question is : How do we, as an Industry, turn the NCUA "Ship" around and head it in the proper direction???
    Ralph E. Reaerdon
  • It boggles the mind that NCUA would perform a CapCorp redo...did they not learn anything from their past mistake? These securities should be held to maturity and losses expensed when they occur.
  • This article is right on the mark. Forcing Credit Unions to take losses on the possible future losses is unbelievable. Your analysis and solution is perfect.
    Stuart Weiner
  • Chip is right in his analysis. NCUA did not choose his path because of their fear of credit unions leaving corporates. Further the fact that NCUA had to use PIMCO for a study shows how incapable they are in regulating corporates. They should have specified modeling and modeling frequency as a normal course of regulation to prevent the mess. Will those who failed in managing the examination process at NCUA loose their jobs just as those CEOs in affected credit unions have? Our industry should demand it.
    NCUA Incompetence
  • This is an excellent ariticle and research. Do we think the government will listen to us?
    Jay Flanagan
  • What is and has been happening with capital in the movement is directly affecting credit unions from serving their members. At a time when the economy needs safe and sound places to save and borrow we have just limited out growth.
  • Chip,

    You are point on: the models being used are no better than kissing cousins of the ones that were used to value these investments and derivatives in the first place. The weatherman analogy is perfect, and the NCUA/PIMPCO believe they can accurately predict events that won't egven begin untl 2016!! Hello.
    Larry Hoffman
  • Another point worthy of mention is, how much did Wescorp pay for this bond? You have it modeled at par. If it was purchased for 80 rather than 100 those "losses" don't really exist. More cash will come back to them than went out--no matter what the market value is today or tomorrow. Again reiterating your point, why are we expensing now what may never happen. Couldn't we solve this problem by disclosing both economic value and market value?
    Sandy Mitchell
  • Given the ebb and flow of the decisions by NCUA, the AICPA, FASB and Congress, what if, NCUA allowed NPCU to retain their NCUSIF deposits with a contra account reflecting the potential reduction in value on a periodic basis beginning with the current 69% estimate? They could update the estimate periodically based as information becomes more clear on the performance of the investments in quesiton and allowing NPCUs to retain the right to their full deposit if in the end the investments perform better than the estimates? In addition, what about billing for actual losses incurred by the Corporates (after their MCA and PIC accounts have been fully depleted) in each premuim billing after considering the agencies access to the NCUSIF deposits?
    Donna Jackson
  • A very good explanation of how sensitive financial models are to assumptions. As a CPA I have frequently disagreed with my profession on "fair value" and "Mark to Model" accounting practices due to the arbitrary nature of these valuations. We should not be forced to take a charge of capital based on these arbitrary models and their assumptions until the loss is more certain, and a loss which doesn't happen until 2016 isn't certain.
  • Obama's administration doesn't really care about credit unions one way or the other; what administration has, for that matter? The government hates to see something that 'works' being left alone to keep 'working', like the credit union movement. Like our lovely Congress, NCUA management has no expertise and doesn't even seem to be able to hire any, NCUA field examiners would rather heckle strong, viable NPCU's on petty non-issues than focus on weak and struggling NPCU's and corporates that actually need closer scrutiny, and if Fryzel hasn't made a deal with the Treasury, I'll eat my hat. What a mess.
  • To quote from an editorial in the April 27, 2009 edition of the Wall Street Journal; "It's a case study in the wyas that panicky regulators hve so often botched the bailout and made the financial crisis worse". While the article was about banks and banking regulators, the quote could just as easily be applied to NCUA and Corporate Credit Unions.

    If you read the article, be sure to continue to the end which states; "No wonder no banker in his right mind trusts the Fed or Treasury, and no wonder nobody but Pimco and other Treasure favorites is eager to invest in the TALF, the PPIP, or any of the other programs that require trusting the government as a business partner". Again, are there not some common threads here. NCUA either needs to clean house or go away. They are totally incompetent.
  • NCUA incompetence. Nothing new here only deteriorating. The Obama administration can't help but think CUs would be better off under the banking regulator. Afterall, BIG is better in this appear brave, but fear-full, new world. Still, CUNA ought to earn their dues and create a class action lawsuit suing the NCUA for dereliction of duty and treason to the CU movement.
  • Your article further supports my claim that NCUA is firmly rooted in the business of putting credit unions out of business. It looks to me like the NCUA is causing most of our losses instead of proactively preventing them. Losses should be written down when they are realized not when our regulator causes them to occur.
  • To Comment #16:

    I completely agree. It seems that most are quick to lean on financial models when the results are in their favor but these same individuals are the first to decry the same models when they don't like the outcome.
  • Chip, explain this one for me. GAAP requires that the bad investments, once deemed impaired, have to be immediately marked down to reflect the entire expected credit loss. In fact FSP FAS 115-2 (part of the change to mark-to-market accounting) specifically says that "an entity should not

    wait for an event of default or other actual shortfall of cash to conclude that some or all of the

    cash flows are not likely to be collected." Are you suggesting we stop following standard accounting?

    If not, how do you propose estimating the eventual credit loss? It has to be a model--the only alternative is guessing.

    I'm not really sure why you're so opposed to the proposed Stabilization Fund. It's designed to do exactly what you propose--allow the premiums to CU's to better match actual losses. Is it an opposition to more borrowing authority? Is it not wanting to see the CLF marginalized? I don't get it....
  • This piece is idiotic. The deal in question is a senior/support tranche of a pool backed by option arm loans. OK, let's dig deeper: Under 10% subordination and over 40 percent of the loans either 60-plus delinquent, foreclosure or REO. Do the math. This bond, baring an act of God, will take losses in the next year or two. Anyone out there want to explain to me how the act of God built into the analysis will come to fruition?
  • Expense now or expense as it Occurs? It doesn't take a rocket scientist to figure this one out. If they take it at the time of occurance, which they should they will write down a lot less.
    Ken McCollum
  • I think this bond needs to be revisited. It has already taken over $10 million in losses and will be totally written off within the next 2 years. Chip, be a man and admit to your errors.